Are DeFi's Money Legos Creating Systemic Risk?

Hello defiers, and happy Friday! Here’s what’s going on in decentralized finance,

• Fulcrum leverages Chai tokens to offer users more interest on their Dai, raising profits but also the question of systemic risk
• SEC’s accredited investor rules are unfair, even after proposed changes
• Maker raises $27.5 from Dragonfly Capital and Paradigm
• Tokenized coffee sold on Uniswap

Dives

Money Legos Maximize Profit But May Add Systemic Risk

Trading platform Fulcrum put DeFi’s money legos together in such a way that its users can use the same asset to collect interest from two sources.

Wait… what? First, know the basics: MakerDAO now allows traders to deposit dollar-pegged stablecoin Dai in a smart contract for it to start gaining interest, or so-called Dai Savings Rate. DSR is financed by the system’s own stability fee, which borrowers pay when closing out their loans.

About one month ago, dAppHub took this a step further and created Chai, a tokenized version of Dai that’s earning DSR. This allows for traders to use their interest-gaining Dai in other ways, instead of having to keep it locked up.

Fulcrum is taking this innovation even further and now Dai in its lending pools, which hasn’t been loaned out, is used to mint Chai. So it will take a portion of Dai deposited by users to lend out, and another portion to exchange for Chai. That means users who lend out Dai automatically start earning Maker’s DSR, which is now at 4 percent, plus Fulcrum’s own interest rate. The result? Now Fulcrum and its lending platform Torque are offering the highest rate for Dai among all DeFi platforms.

Image source: LoanScan

It’s only a matter of time before the other platforms implement similar mechanisms and the gap between rates should close. Compound, the second largest lending protocol after Maker, announced last month that it’s planning to upgrade its cDAI token so that it starts gaining DSR. cDAI is a token which allows traders to automatically start earning interest on DAI. Following that upgrade, cDAI will be enabled as collateral to borrow other assets.

How is This Even Possible

In essence, people will be able to effectively 1) lend out their Dai and gain interest, and 2) have the lending platform lend it out again, and gain more interest. That sounds great, who doesn’t like making more money? But to me, it also sounds like it shouldn’t be allowed. It would be like putting your money in a timed deposit and then somehow bundling that account that’s gaining interest and depositing it at another bank, which gave you additional interest.

The reason why this can even happen is because interest from DSR isn’t coming directly from borrowers. It’s coming from the MakerDAO platform itself, and since the Maker system is securing that interest, you’re not actually lending out your money twice. With DSR, you’re taking on Maker risk, not borrower risk. The counterargument to that is that while DSR interest isn’t coming directly from borrowers, indirectly it is, because it depends on borrowers paying the stability fee when they close out their Vaults (the collateral deposited to take out a loan).

Russian Doll Risk

This whole system seems riskier if you consider that Dai is actually a derivative of ETH (Dai is issued with ETH and other Ethereum-based tokens as collateral). So when depositing Dai in Fulcrum to get that juicy 4.8 percent return on a dollar-based asset you’re taking on Fulcrum’s risk, Chai/dAppHub risk, MakerDAO/Dai risk and Ethereum risk.

What happens in a black swan event that affects the center of this Russian doll? Say for some reason (maybe a sharp drop in ETH or some hack on MakerDAO) Dai loses its peg and trades at well below $1. Dai derivatives like Chai would also collapse. Probably people who had deposited Dai on Fulcrum will want to withdraw it, and the platform will have to rush to cash out Chai for Dai. Also, traders who deposited Dai as collateral or margin on the system, will have their positions liquidated.

But besides widespread panic over Dai crashing, because the system is overcollateralized and smart contracts guarantee the amount of Chai issued corresponds to the amount of Dai, everyone would at least retain their nominal amount of Dai, and Fulcrum itself, even if it had a large exposure to Dai, would continue running. Still, because DeFi is so interconnected, if something as ubiquitous as Dai crashed, the whole system would suffer.

The good thing about money legos is that you can create ingenious structures that maximize profit and/or access for traders. The negative is that it creates systemic risk by definition. One thing to consider: Derivatives are never used as collateral in traditional finance.

SEC Wants to Broaden Accredited Investor Definition

The U.S. Securities and Exchange Commission is proposing amendments to the definition of accredited investor, which would allow more individuals and institutions to invest in private markets. The proposed changes would be a marginal improvement, but they mainly just highlight how unfair current regulations are.

Sums

Maker Raises $27.5 Million in MKR from Venture Funds

The Maker Foundation raised $27.5 million in MakerDAO’s governance token MKR from venture capital funds Dragonfly Capital Partners and Paradigm.

The funds now own approximately 5.5 percent of the total MKR supply. This investment still leaves a16z as the biggest MKR whale after the Maker Foundation itself, as it holds 6 percent of total supply.

Image source: Etherscan

The funds will join a16z as active participants in Maker’s governance. Voting on decisions from changes in the stability fee, to debt ceilings to accepting new tokens as collateral, is done with MKR tokens.

The joint purchase is meant to support Maker’s efforts to increase adoption of Dai in Asia, the foundation’s announcement said.

Tokenized Coffee Added to List of Items Sold On Uniswap

A 200 pound lot of coffee from the Honduran region of El Paraiso lot was tokenized into CAFEtokens using DAI as collateral and then added to a liquidity pool on Uniswap where anyone can trade the tokens. “It’s the first step towards a decentralized commodity exchange,” wrote Robert Lee of Affogatto, the company behind the tokens.

Tweet of the Day: Loan Against Payment Stream

A little late with this tweet, but it’s just too good. Remember the protocol that allows users to “stream” payments, including their salary? That was announced one week ago. Less than a week later, there were already undercollateralized loans being taken out against that payment stream. The pace at which this space is moving is amazing — and very few are paying attention.

Paul Razvan Berg @PaulRBergAaaand it's happened! I'm one of the first people ever to receive an under-collateralised loan on Etheruem. I convinced @pet3rpan_ to lend me 200 DAI by proving him that I'm being paid in real-time on @SablierHQ. See stream with id 20 below. app.sablier.finance/stream/20

Paul Razvan Berg @PaulRBerg@SablierHQ @AlexMasmej @pet3rpan_ now that you can see the money being streamed to me and you know that @SablierHQ is a reputable org that doesn't fire its founders, would you lend me 10% of the stream's worth? I'll pay it back when I get all of the locked up money, that is, on March 11.5:52 AM ∙ Dec 17, 2019138Likes25Retweets

Bytes

EY has made its token and smart contract review service available for public testing (CoinDesk)

A Social Money Exchange Powered by Uniswap (Roll blog)

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About the author: I’m Camila Russo, a financial journalist writing a book on Ethereum with Harper Collins. (Pre-order The Infinite Machine here). I was previously at Bloomberg News in New York, Madrid and Buenos Aires covering markets. I’ve extensively covered crypto and finance, and now I’m diving into DeFi, the intersection of the two.